The Hidden Rally in Canadian Equities (Lee)

Tuesday, May 15th, 2012

The Hidden Rally in Canadian Equities
Using a Low Beta Strategy to Increase Portfolio Efficiency

Alfred Lee, CFA, CMT, DMS, Vice President & Investment Strategist
BMO ETFs & Global Structured Investments
BMO Asset Management Inc.
alfred.lee[@]bmo.com

May 15, 2012
Recent Developments:

• Canadian equities got off to a strong start this year with the S&P/TSX Composite Index (TSX) rallying 6.1% on a total return basis in the two months ended February 29, 2012. The optimism of a global economic recovery has stalled since then and Canadian equities have been weak as a result, with the TSX falling 6.6% on a total return basis. U.S. equities, on the other hand, which we have recommended overweighting over the last 16 months, have been more resilient in the face of the resurfacing of European sovereign debt issues. The S&P 500 Composite Index (SPX) was down only 0.5%, also outperforming the MSCI World Index’s -3.5% loss since March 1, 2012. (Chart A)
• Traditional Canadian equity benchmarks have shown weakness as of late, given the large exposure to sectors such as energy and materials. These commodity intensive areas tend to be highly sensitive to economic conditions as they are widely used in construction and urbanization projects. With increased political gridlock, especially in the Eurozone nations, there may be less clarity in the direction of policy that will be implemented in addressing the economic malaise. As a result, commodity and commodity-related areas have recently shown both weakness and increasing volatility, despite the fundamentals in some sub-groups, such as copper, remaining favourable. The implied volatility levels of the TSX have recently moved above that of the SPX, as indicated by the S&P/TSX Implied Volatility Index (VIXC) and the CBOE/S&P 500 Implied Volatility Index (VIX) respectively. (Chart B)
• Though the fundamentals of the TSX remains attractive, with a current price-to-earnings (P/E) ratio of 13.8x, momentum has remained weak over the last several quarters. However, there have been areas within the Canadian equity market that have shown significant strength. On a relative level, the consumer discretionary, consumer staples, utility and health care sectors have all gained considerably against the TSX so far this quarter, which has largely gone unnoticed. Low beta sectors, or those that are less sensitive to market movements, have been strong year to date (Chart C). These areas, however, tend to be under-represented in major Canadian indices and also in the portfolio of many Canadian investors. Also, interesting to note, a comparison of relative strength trends, show that both the energy and material sectors underperformed the TSX even during the first quarter, when the appetite for risk was strong.

Investment Idea:

• The portfolios of many Canadian investors remain highly exposed to commodity related areas. While we are not suggesting that investors abandon commodities, especially considering that further stimulus would cause commodity prices to rally sharply, we are however recommending also adding exposure to less-cyclical areas to reduce potential volatility that may arise. Moreover, given the aforementioned relative strength trends, some traditional measures of Canadian beta may struggle as commodity related sectors have lagged the TSX. Investors should therefore have exposure to both commodity and non-commodity related areas to reduce volatility in their Canadian equity exposure.
• The BMO Low Volatility Canadian Equity ETF (ZLB) is an efficient way for investors to diversify into less cyclical areas and sectors under-represented in traditional market-cap weighted indices. Some of the largest sector weightings in ZLB are consumer staples (20.9%), consumer discretionary (12.5%) and utilities (11.0%). Therefore, ZLB may be used as a complementary position for many investors, giving them exposure to a wider range of sectors.
• In addition, given ZLB has a much lower beta than the TSX (0.48 vs. 1.00 respectively), it may be used as a complementary position to reduce equity volatility and potentially improve the risk-adjusted returns of an overall portfolio strategy.

Chart A: VIXC Has Moved Above VIX

Source: Bloomberg, BMO Asset Management Inc.

Chart B: VIXC Has Moved Above VIX

Source: Bloomberg, BMO Asset Management Inc.

Chart C: Market-Cap Weighted Indices Are Underweight Sectors That Have Outperformed

Source: BMO Asset Management Inc.

*All prices as of market close May 11, 2012 unless otherwise indicated.

Disclaimer:
Information, opinions and statistical data contained in this report were obtained or derived from sources deemed to be reliable, but BMO Asset Management Inc. does not represent that any such information, opinion or statistical data is accurate or complete and they should not be relied upon as such. Particular investments and/or trading strategies should be evaluated relative to each individual’s circumstances. Individuals should seek the advice of professionals, as appropriate, regarding any particular investment.

BMO ETFs are managed and administered by BMO Asset Management Inc, an investment fund and portfolio manager and separate legal entity from the Bank of Montreal. Commissions, management fees and expenses all may be associated with investments in exchange-traded funds. Please read the prospectus before investing. The indicated rates of return are the historical annual compound total returns including changes in prices and reinvestment of all distributions and do not take into account commission charges or income taxes payable by any unit holder that would have reduced returns. The funds are not guaranteed, their value changes frequently and past performance may not be repeated.

Tags: Alfred Lee, Asset Management Inc, BMO, Canadian Equities, Canadian Equity, Cboe, Cmt, Composite Index, Debt Issues, Economic Malaise, Implied Volatility, Intensive Areas, Investment Strategist, Msci World Index, Political Gridlock, Return Basis, Sovereign Debt, Structured Investments, Volatility Index, Volatility Levels
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Does the Rally Still Have Legs? (Lee)

Thursday, April 12th, 2012

Does the Rally Still Have Legs?
And Things to Keep an Eye on in the Second Quarter

by Alfred Lee, CFA, CMT, DMS
Vice President & Investment Strategist, BMO ETFs & Global Structured Investments
BMO Asset Management Inc.
alfred.lee[@]bmo.com
 
April 12, 2012

Recent Developments:

• U.S. equities registered their best first quarter in 14 years. A definite surprise given the macro-economic and geo-political concerns coming into the new-year. The S&P 500 Composite Index had a total return of 12.6% over the quarter, while the more blue-chip oriented Dow Jones Industrial Average returned 8.8% and the more tech-heavy Nasdaq-100 Index returned an impressive 21.2% over the same period (all in local currency terms). Over the last 16-months, we have recommended an overweight to U.S. equities and continue to do so.
• Much of the rally was attributed to the European sovereign debt concerns being placed on the backburner as policy measures put in place by European Central Bank (ECB), were successful in preventing a liquidity crisis over the short-term. With decreased concerns of an immediate tail-risk event1, global investors shifted their focus to U.S. economic data, which continued to gather momentum, especially on the consumer confidence front. While the first quarter rally had significant breadth, with only the telecom sector trading below its 200-day moving average, three sectors did much of the heavy lifting in driving U.S. equities higher. These sectors were financials, technology and consumer discretionary.
• On a fundamental level, most global equity markets still look attractive from our point of view, with most major equity indices trading below their 10-year averages in price-to-earnings (P/E) ratios, leaving the opportunity for further multiple-expansion if macro-economic risks remain subdued.
• We have been keeping a very close eye at the CBOE/S&P Implied Volatility Index (VIX) over the last four months, trying to find indications of when and if volatility will return. As mentioned in one of our prior reports, the VIX had hit an intraday low of 13.99 several weeks ago, which is abnormally low even in a secular bull-market. Last week, the VIX did pop from 15.83 to 16.65 on an intraday basis on the release of the U.S. Federal Reserve Board minutes. The VIX also moved even higher on news of a weak Spanish debt auction late last week and earlier this week, when the market reopened as a result of last Friday’s non-farm payroll coming in well short of expectations (Chart A). Though the VIX, which currently sits at 18.51, is still below its long-term average of 20.0, it has recently become more reactive to negative headlines, especially compared to its behaviour early in the first quarter. (Chart B). While not an immediate concern, whether equity market volatility can remain compressed is something to keep an eye on in the second quarter.
• Another key indicator to watch for is the price of insuring against a default of Spanish sovereign debt, through the price of its credit default swaps (CDS). More specifically, if the spread between 1-year and 5-year CDS prices on Spanish sovereign debt begins to contract, then the market will likely shift its focus back to the European debt crisis. (Chart C).

Investment Idea:

• If we continue to see an absence of macro-economic concerns, the upcoming U.S. earnings season will likely set the tone for the second quarter. Investors should also keep in mind that the ECB’s Long-term Refinancing Operation (LTRO) was designed to prevent an immediate liquidity crisis and not resolve long-term solvency issues. Given the strong rally in the first quarter, investors may want to consider a more defensive approach in their equity positioning as the technical underpinnings of the market suggest a near-term consolidation. Furthermore, diversification and tactical positioning will remain the key to success in 2012.
• For equity exposure, we remain bullish on the U.S. and prefer non-cyclical areas and/or dividend oriented areas in Canada. For fixed income and credit, we continue to recommend overweighting the short- and mid-part of the yield curve and prefer federal and corporate bond exposure. U.S. high yield corporate bonds and emerging market debt are also currently offering attractive yield at very reasonable volatility levels. Please refer to our most recent Monthly Strategy Report, “Silent Rivers Run Deep,” which can be found on our homepage (www.bmo.com/etfs) for our current strategic and tactical portfolio positioning using ETFs.

Chart A: Frequent Gaps in VIX Indicates Increasing Investor Nervousness

Source: Bloomberg, BMO Asset Management Inc.

Chart B: Volatility Looking Bottomed Out

Source: Stockcharts.com, BMO Asset Management Inc.

Chart C: Could Spain be the Next Problem Child in the European Debt Crisis?

Source: BMO Asset Management Inc.

*All prices as of market close April 9, 2012 unless otherwise indicated.

¹ Tail-risk event: The risk of an outlier or improbable event occurring. Statistically, the event is said to be three standard deviations or more away from the mean, under a normally distributed curve.

Disclaimer:
Information, opinions and statistical data contained in this report were obtained or derived from sources deemed to be reliable, but BMO Asset Management Inc. does not represent that any such information, opinion or statistical data is accurate or complete and they should not be relied upon as such. Particular investments and/or trading strategies should be evaluated relative to each individual’s circumstances. Individuals should seek the advice of professionals, as appropriate, regarding any particular investment.

BMO ETFs are managed and administered by BMO Asset Management Inc, an investment fund and portfolio manager and separate legal entity from the Bank of Montreal. Commissions, management fees and expenses all may be associated with investments in exchange-traded funds. Please read the prospectus before investing. The indicated rates of return are the historical annual compound total returns including changes in prices and reinvestment of all distributions and do not take into account commission charges or income taxes payable by any unit holder that would have reduced returns. The funds are not guaranteed, their value changes frequently and past performance may not be repeated.

Tags: Alfred Lee, Asset Management Inc, Cboe, Cmt, Consumer Confidence, Currency Terms, Dow Jones Industrial, Dow Jones Industrial Average, Economic Risks, Global Equity Markets, Global Investors, Indices Trading, Investment Strategist, Liquidity Crisis, Nasdaq 100 Index, Policy Measures, Quarter Rally, Structured Investments, Telecom Sector, Volatility Index Vix
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Defence That Pays: Dividend Equities as a Long Term Strategy

Thursday, March 29th, 2012

Defence That Pays
Dividend Equities as a Long-term Strategy

by Alfred Lee, CFA, CMT, DMS
Vice President & Investment Strategist
BMO ETFs & Global Structured Investments
BMO Asset Management Inc.
alfred.lee@bmo.com

March 29, 2012
Recent Developments:

• Despite the global macro-economic concerns that remain, year to date, investors have clearly favoured risk-assets as improving sentiment has led global equity markets to rally with significant breadth. Although, investors should not put too much focus on day-to-day headlines, last Thursday’s reading of Europe and China’s weak Purchasing Managers Index (PMI), shows how the global economic recovery remains vulnerable. While we have become more optimistic over the mid-term, we still remain concerned on the structural issues remaining over the long-term, and is why we continue to recommend that investors do not throw caution to the wind.
• News of Greece’s debt restructuring several weeks ago, has put concerns on the backburner; although we believe Greece’s solvency issues remain over the long-term. On a short-term outlook, this has lifted a major overhang on the equity markets. Investors should note, however, that credit default swap (CDS) prices of Portugal still remain elevated (Chart A). Moreover, China’s potential housing bubble and inflation handcuffs the nation’s ability to implement a wholesale monetary easing policy. Thus, unlike 2009, China will not be able to shoulder the global economy.
• The year-to-date rally in risk-assets hinges on whether U.S. economic data can sustain or continue to build positive momentum. Although we have increased our recommended allocation to Canadian equities, we still remain defensive in our composition. Concerns on China should weigh on some commodity-based equities over the short-term, so we recommend that investors look at non-cyclical areas such as dividend paying equities in Canada.
• In addition to being more defensive in nature, lower bond yields should lead investors to look to dividend paying equities to source yield. Currently, the 10-year government bond yield is less than the dividend yield of the S&P/TSX Composite Index (TSX) (Chart B). An aging demographic searching for income distributions should provide a further tailwind for dividend paying equities over the long-run.
• Improving economic data has also recently led the yield curve to shift upwards (Chart C), which has negatively impacted bonds, especially those of longer maturity. As we have become more bullish on equities over the short- and mid-term, investors may want to consider reallocating some bond exposure to dividend paying equities as a way of maintaining overall portfolio yield while decreasing duration risk. Investors should keep in mind that equities and fixed income do react to risk in different manners and therefore should keep in mind their overall portfolio risk composition.

Investment Idea:

• Investors may want to consider the BMO Canadian Dividend Equity ETF (ZDV) as an efficient way to gain exposure to a basket of 50 large and some mid-cap Canadian dividend paying stocks. Currently, the underlying portfolio yields 4.5%, diversified across eight different sectors and a management fee of only 0.35%. In addition to being eligible for a dividend reinvestment plan (DRIP) like our other BMO ETFs, ZDV pays a monthly distribution. We continue to recommend defensive holdings such as ZDV as core positions and more cyclical oriented themes around the peripheral as more tactically oriented themes.

Chart A: CDS Prices on Portugal Remain Elevated

Source: BMO Asset Management Inc., StockCharts.com

Chart B: Canadian Bonds Yielding Less than Canadian Equities

Source: BMO Asset Management Inc., Bloomberg,

Chart C: Yield Curve Shifting Upwards Will Impact Fixed Income

Source: BMO Asset Management Inc., Bloomberg

*All prices as of market close March 27, 2012 unless otherwise indicated.

Disclaimer:
Information, opinions and statistical data contained in this report were obtained or derived from sources deemed to be reliable, but BMO Asset Management Inc. does not represent that any such information, opinion or statistical data is accurate or complete and they should not be relied upon as such. Particular investments and/or trading strategies should be evaluated relative to each individual’s circumstances. Individuals should seek the advice of professionals, as appropriate, regarding any particular investment.

BMO ETFs are managed and administered by BMO Asset Management Inc, an investment fund manager and portfolio manager and separate legal entity from the Bank of Montreal. Commissions, management fees and expenses all may be associated with investments in exchange-traded funds. Please read the prospectus before investing. The indicated rates of return are the historical annual compound total returns including changes in prices and reinvestment of all distributions and do not take into account commission charges or income taxes payable by any unit holder that would have reduced returns. The funds are not guaranteed, their value changes frequently and past performance may not be repeated.

Tags: Alfred Lee, Asset Management Inc, Backburner, BMO, Canadian, Canadian Equities, Canadian Market, Caution To The Wind, Cmt, Credit Default Swap, Debt Restructuring, Economic Concerns, ETF, ETFs, Global Economy, Global Equity Markets, Global Macro, Housing Bubble, Investment Strategist, Purchasing Managers Index, Structured Investments, Swap Cds, Term Outlook, Wind News
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Alfred Lee: Investment Outlook (March-April 2012)

Sunday, March 25th, 2012

Investment Outlook, March 2012

Silent Waters Run Deep

by Alfred Lee, CFA, CMT, DMS, Vice President & Investment Strategist
BMO ETFs & Global Structured Investments, BMO Asset Management
alfred.lee[@]bmo.com

As we articulated in last month’s report, equity market volatility remains eerily quiet given the number of macro-economic issues that remain largely unresolved. With the news of Greece agreeing to a debt restructuring deal, the concern of a European sovereign debt crisis has been put on the back burner and the market has shifted its focus to U.S. economic data, which continues to come in better than expected. The decision by the International Swaps and Derivatives Association Inc. (ISDA) to deem the Greek bond deal a default, also restores faith in credit default swaps (CDS)1 as a viable insurance policy for debt issuances, which will help European sovereigns keep their yields lower over the short-term. Although, U.S. economic data continues to impress, concerns of the other, and larger, PIIGS2 nations, are being overlooked.

The continuation of the current rally does hinge to a degree on U.S. economic data and its ability to continue gathering positive momentum. Most notably, unemployment is down to 8.7% in its December reading, from 9.1% in September. In addition, there is a growing, albeit small, trend of “on-shoring” where manufacturing jobs are coming back stateside, due to rising labour costs in certain emerging markets. Recent optimism of the U.S. economy has led the market to quell their expectations for an additional round of quantitative easing, or further stimulus from the U.S. Federal Reserve (Fed). As a result, our short-term momentum indicators show that gold prices have stalled, and is the reason we remain neutral on precious metals.

Despite the re-pricing of asset markets to reflect improving U.S. economic fundamentals and a lower perception of tail-risk3, the CBOE/S&P Implied Volatility Index (“VIX”)4 remains abnormally suppressed. In mid-March, the VIX had an intraday print of 13.99, which would be considered low during a secular bull-market and well below its long-term average of 20. As volatility has a tendency to quickly revert to its average, we remain cautiously optimistic on risk assets. While we have moved overweight to equities, we remain defensively positioned in our equity exposure, in order to better distribute risk across our strategy. Although we have become more positive on equities over the mid-term, we believe there are unresolved structural issues which will weigh on equities in the long-term.

Notable Changes to the Mix

- Global equities have rallied significantly over the course of the last five months with the MSCI All Country World Index (ACWI) gaining 23.9% from its October lows. More encouraging has been the breadth of the rally, with all sectors contributing to the strength of its ascent. As the overhangs on the market have been more macro-economically related, a rising tide lifts all boats as the markets have re-priced a lower probability of an immediate tail-risk event.

- We have decreased our allocation to fixed income and increased our weight in equities and cash. Though attractive from a fundamental perspective, the equity market continues to look overbought in the short-term based on technical and quantitative-based momentum indicators. Consequently, we anticipate some short-term consolidation. By increasing our cash position, it allows us to be more nimble and take advantage of any upcoming opportunities and slowly increase our weight towards tactical opportunities in equities. In addition, the ongoing equity rally could put upward pressure on interest rate expectations, which is why we have over-weighted the short-and mid-part of the yield curve to lower our duration risk.

- Coming into the new year, we were bearish on Canadian equities. Though we have raised our positioning to neutral, we believe that weaker gold prices and concerns over China targeting lower growth expectations will weigh on the S&P/TSX Composite Index (TSX). We do however remain bullish toward certain areas within Canadian equities such as lower volatility equities and dividend paying equities, and we are recommending the BMO Low Volatility Canadian Equity ETF (ZLB) and BMO Canadian Dividend ETF (ZDV), respectively, to access these areas.

New Additions/Deletions to Strategy:

- One of the areas where we have been bullish over the last sixteen months has been U.S. equities. More specifically, we were bullish on the large-cap blue chip companies, the reason why we have been recommending the BMO Dow Jones Industrials Average Hedged to CAD Index ETF (ZDJ). Though we still favour the stocks in the Dow Jones Industrial Average (Dow), higher oil prices and a buoyant U.S. dollar, will weigh on the multinationals in the Dow. Moreover, improving economic conditions and on-shoring will likely lead to an improving business environment for some of the smaller, more locally based U.S. companies. We are therefore paring back some of our exposure to ZDJ in favour of the BMO U.S. Equity Hedged to CAD Index ETF (ZUE) in our strategy mix.

- Last week, the Fed released the results of the U.S. bank stress test, which came in overwhelmingly positive. Of the 19 banks, 15 were given passing grades. Furthermore a number of the banks were given approval by the Fed to raise its dividends. This news added a further tailwind to the U.S. banking sector, as it continues to show leadership amongst the U.S. equity sectors. Currently, the BMO Equal Weight U.S. Banks Hedged to CAD Index ETF (ZUB), which tracks the Dow Jones U.S. Large-Cap Banks Equal Weight Total Stock Market Index CAD Hedged Index, trades at a forward price-to-earnings (P/E) ratio of 11.9x, a discount to the 13.5x forward P/E of the S&P 500 Composite Index. Our technical indicators suggests that positive momentum in ZUB has returned, something we like to see in assets trading at attractive valuations as we want to avoid value traps. Given the sector remains vulnerable we recommend investors consider utilizing a trailing stop loss order of no more than 10% and limit their allocation to mitigate risk.

Things to Keep and Eye On

Last month, we mentioned that most broad equity market indices, including the TSX, were trading at a discount to their respective 10-year averages. This month we wanted to take a closer look at the TSX to determine which of the sectors look more attractive from a valuation standpoint. We used the current price-to-earnings (P/E) ratios of the sector index relative to its own 10-year average using historical daily data. It should be noted that 10-years may not be a long enough period to demonstrate the secular trend in equities; however, the 2008 financial crisis should also compress a 10-year average P/E ratio, making a more stringent benchmark for determining which sectors are attractive on a historical basis. In addition, investors should also note that since the TSX lacks depth in a number of its sectors, the valuation of those sectors can be heavily impacted by individual companies. Information technology and health care are prime examples of sectors lacking depth.

Recommendation: A number of the sectors trading at a discount to their 10-year average in terms of P/E are well represented in the BMO Low Volatility Canadian Equity ETF (ZLB). Although the market has rotated into more cyclical oriented areas, we continue to favour lower volatility areas in the equity market as a long-term core holding. As mentioned, in our recent BMO Trade Opportunity report, a combination of ZLB with the BMO S&P/TSX Equal Weight Global Base Metals Index ETF (ZMT) provides investors with a solid long-term holding combined with a more tactical oriented opportunity.

Since the 2008 financial crisis, there has been an increasing concern of runaway inflation due to the stimulative measures and accommodative monetary policies of central banks around the world. Although it can be argued that the Consumer Price Index (CPI) is not a good representation of true inflation, especially given the elevated prices of hard assets over the decade, CPI for the U.S. remains at 2.9%, well below its long-term average of 3.4%. One of the key reasons why an increase in money supply has not translated to inflation is due to a slower money velocity7, which has decreased substantially since the 2008 financial crisis as a result of greater uncertainty with the business environment. Should the recent improvement in U.S. economic data and unemployment prove to be a sustained trend, the rate at which money changes hands could increase, eventually making inflation a concern.

Recommendation: As U.S. monetary policy indirectly affects the actions of other central banks and particularly the Bank of Canada, investors should keep an eye on the actions of the Fed. Although not an immediate concern, an uptick in money velocity could potentially make inflation a problem several years down the road. As a result, we continue to favour short- and mid-term bonds as a means of decreasing interest-rate risk (See Cross-Asset Allocation Mix Table for our recommended exposures).

In recent weeks, there has been much discussion about the diverging trends between the VIX and the Credit Suisse Fear Barometer Index (CSFB)5. Both indices are used as a gauge of market sentiment with higher readings indicating increased nervousness with investors. In recent months, the VIX has dropped significantly whereas the CSFB has steadily risen. The VIX is reflective of the market’s current anticipation of volatility over the next 30-days, annualized. The CSFB, on the other hand, is calculated as a zero-cost collar6, using three-month options. As such, there are a number of differences in the two indices, including different maturity terms of the underlying options, making a divergence possible depending on the term structure in volatility. Also worth mentioning, is that the VIX calculates volatility using options on individual companies whereas the CSFB uses index options.

Recommendation: As we noted at the onset of the year, the term structure in the VIX futures curve is currently upward sloping and relatively steep in the first three contracts, which has made a divergence between the two “fear indices” possible. The term structure for VIX can be interpreted as the market’s current expectation for volatility in the future. Although the term structure for the VIX futures changes over time, and it is possible that the term structure could flatten, the VIX is well below its long-term average and cannot get much lower. We continue to advise investors that short- and mid-term bonds should not be neglected as a risk mitigation tool and that investors should continue to maintain exposure to defensive oriented areas in the equity market.

Oil prices have seen a steady rise since early October reflecting an increase in optimism of a global economic recovery. Though political turmoil has had more of a direct impact on the prices of Brent crude (Brent), West Texas Intermediate (WTI) which is more reflective of North American oil prices has seen an indirect impact due to a changing demand and supply equilibrium. Last year on September 26, we recommended investors invest in energy through our BMO S&P/TSX Equal Weight Oil & Gas Index ETF (ZEO), which has gained 13.7% on a total return basis since. Energy companies remain our top investment idea within the commodity sector based on global macro-economic and political forces. Moreover, both Brent and WTI prices tend to strengthen the first seven months of the year, which could provide an additional tail-wind for oil prices.

Recommendation: Although we would never make an investment recommendation based on seasonality alone, the tendency for oil to gain in the first half of the year does provide us with an additional reason to be positive on energy companies. However, as we mentioned last month, since oil does have a tendency to be very reactive to macro-economic risk, we continue to recommend a trailing stop-loss order of 10% on BMO S&P/TSX Equal Weight Oil & Gas Index ETF (ZEO). Investors that acted on the trade in October may also want to consider paring back their exposure to their original allocation.

Cross-Asset Asset Allocation Mix using BMO ETFs (click to enlarge)

Footnotes

1 Credit Default Swaps (CDS): A swap agreement where the seller of the CDS will compensate the buyer in the event of a loan default or other credit event. The buyer of a credit default swap receives credit protection, whereas the seller of the swap guarantees the credit worthiness of the debt security. In doing so, the risk of default is transferred from the holder of the fixed income security to the seller of the swap. As such, a rising CDS price indicates an increasing probability of a default on a fixed income issue, while a declining price indicates a lower probability.
2 PIIGS: An acronym used to refer to the five eurozone nations, which were considered weaker economically following the financial crisis: Portugal, Italy, Ireland, Greece and Spain.
3 Tail-risk: The risk of an outlier or improbable event occurring. Statistically, the event is said to be three standard deviations or more away from the mean, under a normally distributed curve.
4 CBOE/S&P 500 Implied Volatility Index (VIX): shows the market’s expectation of 30-day volatility. It is constructed using the implied
volatilities of a wide range of S&P 500 index options. This volatility is
meant to be forward looking and is calculated from both calls and puts.
The VIX is a widely used measure of market risk and is often referred to
as the “investor fear gauge”.
5 Credit Suisse Fear Barometer (CSFB): measures investor sentiment for 3-month investment horizons by pricing a zero-cost collar. The collar is implemented by selling of a 10% out-of-the-money call (OTM) option on
the S&P 500 Composite (SPX) and using the proceeds to buy an OTM put.
The CSFB level represents how far OTM that SPX put is.
6 Zero-cost collar: consists of the simultaneous sale of one option and using
the proceeds towards the purchase of another option at different strikes.
7 Money velocity: average frequency with which a unit of money is spent on new goods and services produced domestically in a specific period of time.

Tags: Alfred Lee, Asset Markets, BMO, Canadian, Canadian Market, Cboe, Cmt, Credit Default Swaps, Debt Crisis, Debt Restructuring, Economic Fundamentals, ETF, ETFs, European Sovereigns, Gold Prices, Investment Outlook, Investment Strategist, Labour Costs, Market Volatility, Mining, Momentum Indicators, precious metals, Silent Waters, Structured Investments, Volatility Index, Volatility Index Vix
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Outlook: Can Normalization in a Non-Normal Market Persist? (Alfred Lee)

Sunday, February 26th, 2012

Can Normalization in a Non-Normal Market Persist?

by Alfred Lee, Vice President and Chief Investment Strategist,
BMO ETFs and Global Structured Investments
alfred.lee[@]bmo.com

Without question, equity markets around the world are off to a good start in 2012 with a general rotation out of defensive areas and into more cyclical oriented themes. More impressive is the market’s ability to shake off a number of negative headlines already seen in the new year. These include credit rating agency Standard & Poor’s (S&P) recent move to downgrade a number of Eurozone countries including France and following that up with the downgrade of the European Financial Stability Facility (EFSF). Though lower credit ratings typically results in higher borrowing costs when bonds are auctioned, yields of the downgraded European sovereign bonds barely rose after the news. Moreover, credit default swaps (CDS), or insurance against a default on sovereign bonds, have actually been trading at lower prices since the news of the downgrades. This suggests that the moves by S&P were already priced-in, as the downgrades were largely considered to be telegraphed to the market months ago. In addition, the European Central Bank’s (ECB) Long-Term Refinancing Operation (LTRO)¹ and the co-ordinated moves by the six central banks in November to provide cheaper swap borrowing rates has largely removed the perception of tail-risk² in the short term. Through the newly revised rules of the LTRO, the ECB allows banks to borrow funds for three years by posting collateral, to which eligibility requirements have been relaxed significantly. Thus, the perception of solvency of European banks have been significantly improved, despite a number French, Italian and more recently Spanish banks having been downgraded.

From a fundamental perspective, we have considered that most equity markets around the world to offer attractive valuations over the last three months. Though we have reduced our “overweight bonds” recommendation introduced last August to “slightly overweight” last month, we were still overly defensive in our allocation in January. While we remained largely favourable to U.S. equities throughout 2011, which in hindsight proved to be the right call, we have been waiting for momentum to return to Canadian stocks to avoid being caught in a value trap. The Dow Jones Industrial Average (Dow), our top broad equity market pick in 2011, showed a return of positive momentum in October, breaking out of its range-bound pattern and also recently registering a “golden-cross”³ pattern, early January. The S&P/TSX Composite Index (TSX), on the other hand, remained in a clear downtrend pattern since last March and has only recently broken out of that trend. In our equity allocation over the last year, we favoured more defensive oriented themes such as utilities, REITs and low volatility strategies. We continue to favour these themes as longer term core investments but given the strong market rally, we would use equity market pullbacks to tactically rotate some equity exposure to higher beta⁴ areas, as defensive names may lag over the next several months.

What Lurks Beneath?

Last year, the U.S. Federal Reserve (“Fed”) announced they would pledge to keep record low interest rates until 2013. Several weeks ago, in a surprise move, the Fed extended its commitment to low rates to 2014, which was largely recognized as an overly aggressive move, particularly considering that U.S. economic data has been coming in better than expected in most cases. Nevertheless, the move showed that the Fed is willing to take significant measures to maintain a risk-rally and the market now believes that there is a higher likelihood for further quantitative easing should the improvement in economic data lose momentum. As a result, over the next several months we believe an equity market rally may be possible, despite risk assets looking very overbought over the short-term. From a fundamental perspective, global equity markets are attractive and short-term liquidity measures may lead to a multiple expansion in valuations. However, the many global macro-economic concerns that weighed on the market last year largely remain unresolved and any political responses questioned by the market could potentially cause a market sell-off. Sentiment indicators such as the
CBOE/S&P Implied Volatility Index (VIX) are currently below historical averages but are finally showed some reaction to negative news, several weeks ago. As a result, we recommend using pull backs and trailing stop-loss orders to reallocate to equity markets. Risk mitigation tools such as stop-loss orders are critical given margin debt levels remain excessive, which makes a deleveraging event possible should investor sentiment sour over the ongoing European sovereign debt saga.

Tags: Alfred Lee, Attractive Valuations, BMO, Canadian, Canadian Market, Central Banks, Chief Investment Strategist, Credit Default Swaps, Downgrades, ECB, Efsf, Eligibility Requirements, European Banks, Eurozone Countries, Financial Stability, Fundamental Perspective, Negative Headlines, Risk 2, Solvency, Sovereign Bonds, Spanish Banks, Structured Investments
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2012 Outlook: Remain Tactical and Keep Risk in Check (Lee)

Friday, January 13th, 2012

2012 Outlook: Remain Tactical and Keep Risk in Check
Monthly Strategy Report January 2012

by Alfred Lee, CFA, CMT, DMS,
Vice President & Investment Strategist,
BMO ETFs & Global Structured Investments
BMO Asset Management Inc.
alfred.lee[@]bmo.com

Investors will likely be relieved that a turbulent 2011 is now behind us with the new year hopefully bringing a more forgiving investment environment. While there have been a number of positive developments, such as the continued strength of U.S equities and the defensive and yield oriented sectors, investors must remember that we are far from being out of the woods. The European sovereign debt concerns that plagued the markets last year – the single most crucial factor to determining how assets perform this year – remain unresolved. In addition, the many global macro-economic risk items, such as continued deleveraging in developed economies and a potential slowdown in emerging markets, leaves equity markets vulnerable for yet another soft-patch in 2012, particularly if policy response continues to dictate market moves. With an increasing amount of push-pull factors in the market, we expect market volatility to return.

Considering this expectation, investors should dedicate a portion of their portfolio (the “Core”) to a strategic asset allocation mix, enforcing discipline in the portfolio construction process. The remaining portion of the portfolio (“Satellite”) can be used to tactically allocate to sectors and themes that are expected to display relative strength at any particular time. The constant and rapid changes in investor sentiment that we experienced in the second half of 2011 will likely continue this year, and as a result, we are dedicating an increasing allocation to our tactical themes to methodically generate potential alpha and systematically control risk. Though the following are the themes we are currently recommending, we are expecting a faster paced market in 2012 and our goal is to inform investors of major tactical changes in our BMO ETFs Monthly Strategy and Trade Opportunity Reports, although some tactical themes may have changed intra-month.

Asset Allocation Themes

- Volatility shocks will AGAIN be common: In mid-December, the CBOE Implied Volatility Index (VIX) dipped below its 200-day moving average for the first time since last July. Although a positive development, since a lower VIX tends to indicate lessened nervousness, the VIX tends to display seasonality where it has a tendency to drop in December and increase in the month of January. Moreover, its term structure in the futures market currently sits in “contango1,” meaning further dated future contracts are higher priced than closer dated contracts. This suggests the market is pricing in an expectation for higher volatility in the future. As equity prices still remain extremely sensitive to negative
headlines and there remains a large number of headline risk items out there, we believe volatility shocks (“volatility-squared”) to remain a constant theme in 2012.

- Slightly overweight bonds: Since last August, we have recommended an overweight to fixed income relative to equities. That’s not to say we are bearish on equities as we have recently seen some positive developments in the equity markets, and we would advise a higher allocation to equities as we did last August. However, we continue to favour bonds over Canadian equities at least over the first quarter. The greenback, which remains in a secular decline, is gathering strength over the short term and we expect this to cause headwinds for the commodity heavy S&P/TSX Composite Index (S&P/TSX). Unlike U.S. equities, which have broken out and are looking increasingly bullish, the S&P/TSX is testing but has yet to break its downtrend pattern. As we anticipate commodity and equity markets to be volatile in the first several months of the new year, investors should not neglect bonds despite lower than historical yields for their volatility mitigation qualities. We do believe equity markets could rally later in the year, if and when the market begins focusing on the micro-economics rather than the macro-economics. We will however be looking to increase our equity weighting, if and when the TSX is able to break its downward pattern over the last several months. Below we highlight areas in fixed income and equity markets that we believe to be attractive.

Equity Themes

- Low beta trades continue to fare well: As we anticipate volatility-squared to be elevated in the first half of 2012, stocks that are less sensitive to market movement, or those with a lower beta, will likely outperform. Although lower beta stocks participate less on the upside, they also capture less of the downside, which is critical when equity market volatility is elevated. Cyclical stocks on the other hand, tend to have a higher beta and outperform when the market is trending higher as they capture more upside and downside market movements. As the year progresses, however, and should the market get further clarity on a resolution to the European sovereign debt issues, that may be a more opportune time to rotate to more cyclical stocks. The BMO Low Volatility Canadian Equity ETF (ZLB) is an efficient way for investors to get exposure to a diversified portfolio of lower beta large-cap Canadian equities.

Potential Investment Ideas:
- BMO Low Volatility Canadian Equity ETF (ZLB)
– BMO Equal Weight Utilities ETF (ZUT)
– BMO Covered Call Utilities ETF (ZWU)
– BMO Global Infrastructure Index ETF (ZGI)

- U.S. equities outperform in first half of year: Similar to our position throughout 2011, we remain favourable on U.S. equities, particularly blue-chip multinational names. The Dow Jones Industrial Average (Dow), which was our top-pick for U.S. equity exposure last year, remains our preferred exposure as it still trades at an attractive valuation with a price-to-earnings (P/E) ratio of 12.7x, well below its 10-year average of 16.6x and equivalent to the MSCI World’s current P/E of 12.7x.

On a global macro-economic level, as we expect European sovereign debt issues to remain in the first several months, investors may look to avoid higher volatility areas such as emerging markets and commodity intensive markets as global growth will be uncertain until later in the year. From a technical perspective, the Dow entered a golden-cross where its 50-day moving average (MA) crossed above its 200-day (MA), leading to further buying, thus creating a tailwind. A break above last April and June’s highs would be seen as further confirmation of a U.S. equity breakout. Investors that are looking to enhance income and potentially mitigate some volatility may want to consider a covered call strategy on the Dow.

Tags: Alfred Lee, Asset Management Inc, Cmt, Control Risk, Economic Risk, Global Macro, Investment Environment, Investment Strategist, Investor Sentiment, Market Moves, Market Volatility, Paced Market, Policy Response, Portfolio Construction, Pull Factors, Rapid Changes, Relative Strength, Sovereign Debt, Strategic Asset Allocation, Strategy Report, Structured Investments
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U.S. Blue Chips Continue to Lead (Lee)

Friday, January 6th, 2012

U.S. Blue Chips Continue to Lead
Dow Jones Industrial Average Hits “Golden-Cross”

Alfred Lee, CFA, DMS
Vice President & Investment Strategist
BMO ETFs & Global Structured Investments
BMO Asset Management
alfred.lee@bmo.com

January 5, 2012

Recent Developments:

• Last Tuesday, the Dow Jones Industrial Average (Dow), hit a “golden-cross” pattern, where its 50-day moving average (MA) crossed above its 200-day MA. This tends to be a bullish indicator since its short-term average is increasing faster than its longer-term average, suggesting momentum is trending higher. As this tends to be a widely followed technical signal, it does have a tendency to create some tailwinds as it is often met with additional buying (Chart A).
• While the recent golden-cross in the Dow can be seen as bullish, there are a number of global macro-economic risk items that remain. As a result, equity market volatility may again remain elevated for much of 2012. Although the CBOE Dow Jones Volatility Implied Index (VXD) which is also known as the “Dow VIX” trended significantly lower in the month of December, equity volatility tends to exhibit strong seasonality patterns, with VXD falling 7 of the last 10 Decembers and declining 10.6% on average in those 10 Decembers (Chart C). Currently, the futures term structure for the implied volatility index on the more broad based CBOE S&P 500 Implied Volatility Index (VIX), is positively sloped where its further dated futures contracts are higher than the near dated contracts. This indicates that the market is anticipating volatility to rise in the future.
• Similar to the beginning of 2011, we remain bullish on U.S. equities, particularly the Dow since many of the constituents are blue-chip companies with multi-national reach. Our thesis from last year remains unchanged. Many of these companies have strong cash balances, enabling them to raise dividends and/or buy-back shares while remaining well-capitalized should markets decline. From a fundamental perspective, the Dow remains attractive, trading at a current price-to-earnings (P/E) ratio of 12.9x. Last year, with the majority of equity markets facing significant headwinds, many of the Dow companies such as McDonalds Corp. and International Business Machines Corp. (IBM), made multiyear, if not all-time highs, which should be seen as a positive. In addition, from a technical perspective, the Dow displays excellent breadth with 22 of its 30 constituent companies trading above their 200-day MA. This is constructive as it suggests the majority of its constituents are driving the index higher, rather than just a few strong performing companies.

Potential Investment Opportunity:

• Canadian investors seeking exposure to the Dow without having to worry about currency volatility may want to consider the BMO Dow Jones Industrial Average Hedged to CAD Index ETF (ZDJ). Through ZDJ, investors can access the 30 blue-chip stocks in the Dow on a cost efficient basis. Alternatively, investors that are bullish on the Dow but believe the index will be slow and steady or range bound, may want to consider the BMO Covered Call Dow Jones Industrial Average Hedged to CAD ETF (ZWA). A covered call strategy allows investors to enhance yield while potentially mitigating some volatility but will underperform a non-covered strategy in a rapidly ascending market. For further information on the mechanics behind a covered call strategy, please click “Covered call Option Strategy” in the “Related Links/Downloads” section in the following link.

Chart A: The Dow Hits a “Golden-Cross”

Source: BMO Asset Management Inc., Bloomberg

Chart B: Implied Volatility on the Dow (VXD) Fell Significantly in December

Source: BMO Asset Management Inc., Bloomberg,

Chart C: Implied Volatility Tends to Fall in December Exhibiting Strong Seasonality

Source: BMO Asset Management Inc., Bloomberg

*All prices as of market close January 3, 2011 unless otherwise indicated.

Disclaimer:
Information, opinions and statistical data contained in this report were obtained or derived from sources deemed to be reliable, but BMO Asset Management Inc. does not represent that any such information, opinion or statistical data is accurate or complete and they should not be relied upon as such. Particular investments and/or trading strategies should be evaluated relative to each individual’s circumstances. Individuals should seek the advice of professionals, as appropriate, regarding any particular investment.

BMO ETFs are managed and administered by BMO Asset Management Inc, an investment fund manager and portfolio manager and separate legal entity from the Bank of Montreal. Commissions, management fees and expenses all may be associated with investments in exchange-traded funds. Please read the prospectus before investing. The funds are not guaranteed, their value changes frequently and past performance may not be repeated.

The Dow Jones Industrial Average^SM is a product of Dow Jones Indexes, a licensed trade-mark of CME Group Index Services LLC (“CME”), and has been licensed for use. “Dow Jones®”, “Dow Jones Industrial Average^SM”, “Dow Jones Canada Titan 60” “Diamond” and “Titans” are service marks of Dow Jones Trademark Holdings, LLC (“Dow Jones”)and have been licensed for use for certain purposes. BMO ETFs based on Dow Jones indexes are not sponsored, endorsed, sold or promoted by Dow Jones, CME or their respective affiliates and none of them makes any representation regarding the advisability of investing in such product(s).

Tags: Alfred Lee, Blue Chip Companies, Blue Chips, Cboe, Chart C, Decembers, Dow Jones, Dow Jones Industrial, Dow Jones Industrial Average, Economic Risk, Futures Contracts, Global Macro, Golden Cross, Implied Volatility, Investment Strategist, Market Volatility, Structured Investments, Tailwinds, Volatility Index Vix, Vxd
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A Test of Fortitude & Discipline: 2011 in Review

Friday, December 23rd, 2011

Monthly Strategy Report December 2011

by Alfred Lee, CFA, DMS, Vice President & Investment Strategist,
BMO ETFs & Global Structured Investments
BMO Asset Management Inc., alfred.lee(@)bmo.com

Just when you thought financial markets couldn’t get any more extreme, they suddenly prove otherwise. Such was the theme over the course of 2011, a year where market volatility caused constant changes in sentiment and significantly frustrated many investors. Global equities fell 6.5% on the year, as indicated by the MSCI World Index (Total Return), which should actually be viewed as a positive given the macro-economic backdrop.

As the year progressed, the market was hit with an increasing number of negative headlines including: the unfortunate Japanese earthquake/tsunami; the downgrade of U.S. Treasuries by Standard & Poor’s; deteriorating sovereign debt issues in Europe; and growing concerns of a hard landing in China. As a result, most of the gains experienced in broad market equity indices during the first quarter of the year rapidly reversed course as sentiment became increasingly bearish from these news items during the last six months of the year. Moreover, since August, both realized and implied volatility have remained elevated, providing a serious test of discipline for investors.

We started the year with a more bullish tone as markets continued to enjoy the effects of “QE2” (the second instalment of quantitative easing by the U.S. Federal Reserve). However, as the year progressed and market sentiment soured, our Global Inter-Market Model showed developing trends in defensive-oriented assets. Consequently, and also considering the worsening macro-economic data, we issued a report on August 15, titled “Navigating Market Volatility” where we recommended a more defensiveoriented portfolio strategy. Given the rapidly changing market environment, our recommendations in 2011 were significantly more tactical than the previous year. Below, we highlight some of the recommended themes throughout the year.

Asset Allocation Themes:

1) “Overweight Equities Relative to Bonds:”

This asset allocation decision fared extremely well during the first quarter with the S&P/TSX Composite Index to DEX Universe ratio expanding until April 8, as Canadian equities outperformed bonds. Though we remained optimistic on equities through June, as the summer progressed, both macro-economic data and technical indicators suggested a greater emphasis to fixed income. We therefore recommended an overweighting in bonds in our previously mentioned August 15 report. That tactical shift to fixed income has served us well as our BMO Aggregate Bond Index ETF (ZAG) has gained 3.5% on a total return basis since that report, while the S&P/TSX Composite Index returned -6.7% on a total return basis from the same period. That tactical shift led to a difference of 10.2% in performance.

2) “Be Prepared for Sudden Upside Volatility:”

At the beginning of the year and a theme highlighted throughout 2011 was to prepare for constant shocks in volatility or what we noted as “volatility-squared,” as markets were becoming more behaviourally driven and increasingly reactive to negative headlines.

Tags: Alfred Lee, Asset Management Inc, BMO, Broad Market, Debt Issues, Economic Backdrop, Global Equities, Investment Strategist, Japanese Earthquake, Market Environment, Market Equity, Market Model, Market Sentiment, Market Volatility, Msci World Index, Negative Headlines, Portfolio Strategy, Sovereign Debt, Strategy Report, Structured Investments
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The Return to an Era of Income Investing (Lee)

Wednesday, November 30th, 2011

The Return to an Era of Income Investing

by Alfred Lee, CFA, DMS, Vice President & Investment Strategist,
BMO ETFs & Global Structured Investments, BMO Asset Management
alfred.lee(@)bmo.com

With the ongoing European sovereign debt saga dragging on and critical decisions being postponed, its impact continues to weigh on global equity markets. The earnings story at the company level, particularly in the U.S, that we’ve been bullish on throughout the year continues to keep stock markets moderately buoyant. Over the last several months, a tough battle between macro- and micro-economics has compounded volatility. The CBOE S&P Implied Volatility Index (VIX) and the S&P/ TSX 60 Implied Volatility Index (VIXC) currently sit at 33.98 and 28.89, respectively, well above their normalized ranges, indicating continued fear in the market place. From a global macro perspective, credit default swaps (CDS) or the cost of insuring a default on the sovereign debt of Greece and Italy recently hit new records. The positive developments over the month have been the stepping down of prime ministers from both Greece and Italy. With Mario Monti now the prime minister of Italy and Lucas Papademos the new prime minister of Greece, this changing of the guard as well as their deep economic experience may help restore some confidence with investors. As a result, the performance of global equities for the remainder of the year depends on whether this deadweight on investor optimism from Europe can be lifted. If so, the focus of the market can quickly shift to the earnings of companies, which continue to come in better than expected. If confidence is not restored however, markets may potentially fall below their October lows, leaving the possibility of the much desired year-end Santa Claus rally extremely binary.

Despite the uncertainty, which we feel will unfortunately continue to weigh on the markets, one of the few things that remains quite certain for the next two years is that we will continue to see a low interest rate environment. As U.S. Federal Reserve Board (Fed) chairman Ben Bernanke pledged to keep interest rates near or at historic lows until at least 2013, other central banks around the world will likely be forced to follow suit. Otherwise they risk causing their currency to rise with a higher relative interest rate, thus negatively impacting the country’s exporting industry. Dividend paying or income producing strategies are one of the themes we have recommended throughout the year, and one that we continue to recommend. As we pointed out last year, a 10-year Bank of Canada note now yields less than the dividend yield of the S&P/TSX Composite Index. Similarly, the yield on a 10-year U.S. Treasury note is less than that of the dividend yield of the S&P 500 Composite Index. Although this condition will likely not hold as the appetite for risk returns, the spread between the yield of government bonds and equities will likely remain well below historical averages. This is a recent key development which should lead investors to continue chasing yield oriented investments, causing these areas to likely outperform.

Back to the Old: Dividend Investing

The returns from a stock are derived from two components: capital gains and dividends (or distributions). Since the 1990’s chasing capital gains has been an effective strategy for investors – and for good reason. A perfect storm of rapidly evolving technology, baby-boomers entering their peak earnings age and deregulation were just a few of the factors which led a number of equity market indices around the world to see their most unprecedented rallies on record. Between 1980 and 2001, the Dow Jones Industrial Average Index and the S&P/TSX Composite Index gained 1186% and 393% respectively. Prior to this era, investing in solid companies that provided sustainable dividends was the key to a successful investment strategy, a key factor to the investment approach of investing legends such as Warren Buffet. In the current market environment where volatility has become (and will likely remain) more of a norm than an exception, the capital gains portion of a stock will become more unpredictable. The dividend portion of an equity investment, on the other hand, is more reliable.

Tags: Alfred Lee, Credit Default Swaps, Critical Decisions, Deadweight, Economic Experience, Global Equities, Global Equity Markets, Global Macro, Investment Strategist, Investor Optimism, Macro Perspective, Mario Monti, Micro Economics, New Prime Minister, Prime Minister Of Greece, Prime Minister Of Italy, Sovereign Debt, Structured Investments, TSX 60, Volatility Index Vix
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Volatility Mitigation Strategies in an Uncertain Market (Lee)

Wednesday, November 2nd, 2011

by Alfred Lee, CFA, DMS, Vice President & Investment Strategist, BMO ETFs & Global Structured Investments
BMO Asset Management Inc.
alfred.lee(@)bmo.com

Volatile, temperamental, undecided, distorted… you decide the term to sum up the market’s recent behaviour. Though investor sentiment was quick to bounce between “risk-on” and “risk-off” coming into 2011, the pace at which the market changes its mood has become even more rapid since early August. The catalyst to the great uncertainty has been a myriad of events. The primary culprits have been the downgrade of U.S. Treasuries by credit rating agency, Standard & Poor’s, the European Sovereign debt issues coming to a boil and increased concerns of China’s economy headed for a hard landing. With these three areas struggling, global economic growth could continue to face headwinds, which may also place pressures on global equity markets, despite the recent optimism on the European bailout. Our view is that lower growth and higher volatility will be with us for quite some time as such periods have historically followed extended secular bull-runs.

The CBOE S&P Implied Volatility Index (VIX), which is widely recognized as a “fear index” or a gauge to investor sentiment, has itself been volatile due to this uncertainty. In addition, it has remained significantly elevated since the beginning of August. Though the market swings may be good for traders, it has been difficult for longer-term investors, especially those relying on fundamentals. The story at the company level, although promising, has largely been weighed down by the macro-economic and political headlines and markets have followed technical swings. Volatility has a tendency to be mean-reverting, but as we have mentioned throughout the year, one consistent theme is that we do expect volatility to see sudden shocks on a frequent basis, due to the sensitivity of investors’ sentiment to negative headlines. Investors as a result, should consider strategies that could potentially help reduce volatility in their portfolio and/or increase income to wait out the turbulence.

Consideration #1: Reduce Equity Beta

At the onset of the year, one of our major asset allocation strategies was to moderately increase our allocation to non-traditional fixed income such as emerging market sovereign debt and U.S. high yield bonds. Though we don’t suggest a large allocation, it should help investors increase their portfolio yield. As these areas tend to be more sensitive to macro-economic factors than traditional fixed income, our recommendation has been to offset some of this risk by reducing beta in the equity component of your portfolio. Investing in lower beta stocks, or equities that are less sensitive to market movement, could potentially help investors reduce some of the market noise.

Financial academia, has always taught us that higher returns can only be generated through higher risk. More recent studies, however, have shown that lower beta equities have actually outperformed over the long-term. Thus investors may not necessarily have to overexpose themselves to risk in order to maximize their returns. The implementation of lower beta stocks could therefore help investors as a volatility reduction strategy and potentially increase their long-run returns, thus creating a more efficient portfolio strategy. Lower beta stocks could be utilized either as a core strategy or a tactical overlay in this challenging market environment.

Potential Investment Idea:
- BMO Low Volatility Canadian Equity ETF (ZLB)

Consideration #2: Increase Dividends

In the 1990’s, or what was dubbed “the new era,” high flying growth stocks that provided capital gains were the theme of choice for most investors. Historically, however, the majority of the returns from a stock have been attributable to the dividend portion of the investment. Since the 2008 financial crisis, market participants have been looking for equities to “normalize” and higher growth stocks to come back to favour. It can be argued however that we have already normalized, with the outperformance of high growth stocks in the decades past being more of an anomaly. In addition, with U.S. Federal Reserve Chairman, Ben Bernanke, pledging to keep rates low until at least 2013, this may lead to a high demand for yield oriented assets and thus outperformance by dividend paying securities.

Regardless of how the final details of the European debt situation is laid out and how the U.S. handles its growing deficit, an increase in austerity measures is likely to be involved. As a result, the macro-economic backdrop will likely continue to trickle down to the company level. Investors may therefore want to consider companies with sustainable dividends and diversification across sectors as slower growth environment will likely impact various industries differently.

Potential Investment Idea:
- BMO Canadian Dividend ETF (ZDV)

Consideration #3: Covered Call Strategy

One strategy that we have favoured during the year are covered call strategies, which involves going long equities and then selling call options against some of those positions. (For a more detailed explanation of the mechanics behind a covered call strategy, please see the white paper on our website www.bmo.com/etfs.) This is a consideration for investors that may want to both potentially reduce volatility and raise income.

In a bear market, as we currently find ourselves in, a covered call option writing strategy will help investors raise yields in their portfolio strategy while slightly limiting the downside risk by the option premiums. Covered call strategies will however underperform a non-covered strategy in an aggressive bull market. A number of studies have shown that covered call strategies may offer better risk/return profiles than an uncovered strategy. The addition of covered call strategies in your portfolio can thus potentially improve its efficiency. Though investors should always consider their risk-adjusted returns, in today’s market environment, it is even more important to do so.

Potential Investment Idea:
- BMO Covered Call Utilities ETF (ZWU)
- BMO Covered Call Dow Jones Industrial Average Hedged to CAD ETF (ZWA)
- BMO Covered Call Canadian Banks ETF (ZWB)

At the time of writing this report, the market is still anticipating final details out of the European Union Summit in how they will deal with their sovereign debt crisis. Though the markets have rallied on optimism, the deadline has been moved back a number of times already, which may leave us in another situation where leaving key decisions to the eleventh hour may be frowned upon by the market. Regardless of whether a solidified plan is eventually released or not, it may be a short-term solution, and the devil may be in the details as the recent rally has been lifted by unbacked optimism at the time of this report. Regardless, the economic growth in the coming decade may be muted to what we’ve been accustomed to in the last two decades and volatility is likely to remain with us, with a number of unresolved economic concerns. Investors may therefore want to consider reducing volatility and/or raising income as part of their portfolio strategy using the considerations previously discussed as they are portfolio construction ideas for long-term investors.

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Tags: Alfred Lee, Asset Management Inc, Bonds, Canadian, Cboe, Consistent Theme, Debt Issues, Fear Index, Frequent Basis, Global Economic Growth, Global Equity Markets, Headwinds, Investment Strategist, Investor Sentiment, Market Swings, Mitigation Strategies, Political Headlines, Structured Investments, Sudden Shocks, Term Investors, Volatility Index Vix, Year One
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